The Most Important Tax Break Is the One That Nobody Talks About

If you really want to raise revenues, the Holy Grail isn't capping tax deductions, as Romney proposed, or raising the top marginal rate, as Obama proposed. It's taxing investment income like ordinary income.

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Suddenly, Republicans are all about increasing tax revenues from rich people. In the last weeks of the campaign, Mitt Romney talked about capping itemized deductions for high-income taxpayers (which, unfortunately for his arithmetic, would not nearly have compensated for the lower tax rates he proposed). John Boehner has told his caucus that they have to be willing to accept increased tax revenues (but out of the other side of his mouth says that tax rates cannot be increased). Glenn Hubbard, in the Financial Times, also suggests increasing revenues by closing loopholes: "Tax deductions should be scaled back, especially in the areas of mortgage interest, charitable giving and employer-provided health insurance."

What do all of these proposals have in common? They pass silently over the most important loophole for the rich: artificially low tax rates on investment income, whether capital gains (profits from sales of assets) or dividends (cash distributions from corporations to shareholders).

Why won't a limit on deductions solve this problem? Because itemized deductions, like those for mortgage interest or charitable contributions, are only one type of tax loophole. Another is compensation that is not counted as income to begin with. It is "excluded," which is different from being "deducted" like employer-provided health benefits. And another is simply applying a lower tax rate to certain types of income. Since 2003, both long-term capital gains (sales of assets held for over one year) and most dividends have been taxed at a maximum rate of 15 percent, while the top rate on "ordinary" income (from, you know, working) has been 37.9 percent, if you include the Medicare payroll tax. This is why Mitt Romney, despite his hundreds of millions of dollars of wealth, pays a lower average tax rate than many middincome Americans.

The loophole for investment income is one of the biggest ones that exist, worth about $440 billion over the next five years (2013-2017).* If the goal is for rich people to pay more in taxes, this is the most important loophole to close. Lower rates on investment income overwhelmingly benefit not just the modestly affluent, but the super-rich. According to the Tax Policy Center, households that make more than $1 million make up just 0.3 percent of all households but reap 67 percent of the benefits of this one loophole. That shouldn't be surprising, because the investment assets that earn income mostly belong to the rich: the average million-dollar-plus household receives almost $800,000 in investment income. (Middle-class people own their houses, but the first $500,000 in capital gains from the sale of a house by a married couple are tax-free; and most middle-class people's stock investments are in tax-free retirement accounts.)

This is what the truly rich really care about. As I've written before, the tax rate on capital gains is the most important line in the tax code for them. The employer health plan exclusion and the mortgage interest deduction are just peanuts, and they don't get some other deductions (like the state and local tax deduction) because of the alternative minimum tax.

Taxing income from investments the same as we tax income from labor would raise hundreds of billions of dollars in revenue almost exclusively from people who can afford it. So why isn't anyone considering it?

Republicans don't want to because, well, they are the party of the super-rich. Low taxes on investment income are the untouchable central plank of the Republican platform.

What about Democrats? President Obama has proposed letting the maximum rate on capital gains rise to 20 percent, where it was set in 1997 by President Clinton and then-Speaker Newt Gingrich, on households earning more than $250,000. But that's it. And now Democrats seem to be warming to the idea of limiting itemized deductions, which purports to raise taxes on the rich but is relatively trivial to the super-rich.

Instead, why don't they push for eliminating preferences for investment income, or at least raising the capital gains rate to 28 percent, where it was set by Ronald Reagan in 1986? They can't possibly think it would be bad for the economy, since the evidence for any relationship between capital gains rates and economic growth is dubious. Since the tax increase would only affect the very rich, it would have little impact on consumption and economic activity. And wouldn't it be great to fight for equal treatment of labor and capital, and a smaller national debt, at the same time?

My cynical instincts say that Democrats don't want to upset the hedge fund establishment any more than they already have. But Barack Obama, you will never run for re-election again. Now is your moment. Don't waste it.

*To estimate this properly, you have to add up two numbers from two different reports. The CBO estimates the impact of letting the 2003 tax cut expire (row 86 in this spreadsheet), which would restore the 20 percent rate set in 1997; the OMB estimates the impact of taxing capital gains not at 20 percent but at the same rate as ordinary income (Tax Expenditures Spreadsheet, Table 17-1, row 99). This calculation leaves aside some of the other egregious aspects of capital gains taxation, such as step-up of basis on death, which will cost $180 billion over the next five years